Greenspan defends Fed

In today’s Wall Street Journal, former Fed chairman Alan Greenspan comes out defending the Fed saying it is not what led to the current crisis. In tandem with weakening market forces, he specifically attributed the crisis to the significant reductions in long-term rates leading to a lower capitalization rate, then resulting to a real estate bubble. Greenspan attempts to say that the correlation between short-term and long-term rates, which have gone down to single digits in recent years, has disappeared.

After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates — such as the fed-funds rate — to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble.

He went on to dispute the claims of his colleague John Taylor, who similarly agreed with many leading economists by saying had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his “Taylor Rule,” “it would have prevented this housing boom and bust.”

For Greenspan, when it is an issue of global forces affecting the overall economy, then it is beyond merely a case of failed monetary policy. In such a case, he proposes that the appropriate policy need not be heavy regulation for it tramples on productivity. Instead, the government should work on having higher capital requirements and more stringent procedures to uncover frauds in the system.